How to avoid the hidden pension tax trap that could wipe tens of thousands off your family's inheritance
Updated:
Families are bracing themselves for a brutal change to inheritance tax rules as speculation grows that the Chancellor could launch a raid in the Autumn Budget.
But many are already on track to pay thousands – or even hundreds of thousands – more to the Treasury because of a change Rachel Reeves made last year.
And while many dismiss IHT as a problem solely for the very rich, Wealth and Personal Finance analysis shows all middle-class families should prepare for a tax attack.
From April 2027, pension pots will be included within people’s estates for IHT purposes, dragging more households into the net.
We ran six examples of families, analysed with the help of wealth management firm Quilter, all of whom currently have small and, in some cases, no IHT liability.
In all but one case, they face hefty tax bills by 2030.
And with Rachel Reeves reportedly eyeing a change to gifting tax rules around IHT, many families will no longer be able to lower their tax bill in the same way they can today.
From April 2027, pension pots will be included within people’s estates for IHT purposes, dragging more households into the net
A couple in their late 30s with a young family might not consider IHT when they sit down and talk about their finances. However, our analysis shows they are on course for a giant bill – unless they start planning soon.
However, families can be left with a huge tax bill at any age if disaster strikes.
In our scenario, this young family owns a £750,000 home with £650,000 left on their mortgage, and have collectively saved £100,000 in their defined contribution pensions. They also have £50,000 in Isas and have £20,000 in cash savings.
Their total assets add up to £920,000, but their estate is valued at £170,000 after deducting their mortgage debt and their combined pension pots of £100,000.
Individuals can pass on their assets tax-free if the value of their estate – minus mortgage debts and pensions – is below the £325,000 nil rate band threshold.
Homeowners are also entitled to the £175,000 nil rate residence relief if they pass on their property to direct descendants.
A young family might not consider IHT when they talk about finances. However, our analysis shows they are on course for a giant bill – unless they start planning soon
Under the current IHT rules, the couple are well within their combined £1million nil rate band and residence nil rate band allowances, which means their estate wouldn’t face any inheritance tax.
However, if their assets appreciate in line with Quilter’s analysis, their family home would be worth £848,556 in five years’ time, with an extra £100,000 paid off their mortgage.
Their pension pots would be worth a combined £127,628, while their savings increase to £106,442, including an additional £20,000 contribution into an Isa over five years, plus investment growth.
By 2030, the value of their estate will have jumped to £532,627, once their mortgage debt is deducted.
It means they still fall within the tax-free allowances but the inclusion of pensions has seen the value of their estate triple in five years.
If they continue to contribute to their pension pots, savings and their house increases in value, their children will almost certainly be liable to pay the death duty in the coming years.
Our second couple are in their 50s with grown-up children and are wealthier with a slightly more valuable home and a significantly bigger pension pot.
Their £800,000 mortgage-free home and £300,000 pension pots, plus £105,000 in savings, bring the total value of their assets to £1.205million.
The total value of their estate for IHT purposes is £905,000, after deducting their pension pots, meaning they fall within the nil rate and residence nil rate bands and their beneficiaries will not incur any tax under current rules.
By 2030, the value of their home could increase to £905,127, according to Quilter analysis, while their pension pots will increase to £382,884.
Assuming our couple in their 50s add another £20,000 to their Isa, this will grow to £115,721, while their cash increases by 2.5pc annually to £33,942.
By 2030, the total estate will be worth £1,437,674, including their pensions, After taking into account the £1million tax-free allowance, the beneficiaries will have to stump up £175,070 for their £437,674 taxable estate.
Our third family are similarly well-off, with a £1million mortgage-free home, £600,000 in their pensions and £150,000 across their Isas and cash savings.
Their large detached home in the South East is more expensive, which means they would incur IHT on their £1.15million estate.
This leaves their adult children with a £60,000 IHT bill if they were both to die before April 2027.
While many of their generation had defined benefit pensions, which are lost on the second spouse’s death, our retired couple in this example have transferred out into defined contribution funds, which are invested and will increase to about £765,800 by 2030.
In five years’ time, their estate could be worth £2,101,376, assuming their cash savings increase by 2.5pc and they put away £20,000 into their Isas.
If both died in 2030, they would still be under the age of 75, which means their pension funds will not be liable for income tax when their beneficiaries withdraw funds.
But their pension pots will be included for IHT purposes.
Their children could face a tax bill around seven times the amount they’d incur today, because their taxable estate will jump from £150,000 to £1,152,064.
This is because their overall assets are over £2million and so, for every £2 that the value of their estate exceeds the threshold, the residence nil rate band will reduce by £1. The overall IHT due is £460,825.
Currently, their total taxable estate minus their £900,000 pension and tax-free allowances, is £370,000 with an IHT bill of £148,000
Our next retired couple are in a similar financial position to our previous couple, but by 2030 will be over the age of 75.
This means their pension beneficiaries would pay income tax at their marginal rates, if they withdraw money from the inherited pots. Their £1.25million home will increase in value to over £1.4million but their pension pot will fall from £900,000 to £750,000 as they take out cash for their living costs or to gift to family and friends.
Ian Cook, financial planner at Quilter, says there has been a ‘noticeable’ shift in behaviour since the Chancellor announced changes to IHT last autumn.
He is seeing a renewed focus on gifting, while the current IHT thresholds remain frozen.
He adds: ‘Whether it is using the annual £3,000 exemption, making small gifts to multiple recipients, or giving larger sums that fall under the seven-year rule, people are acting sooner rather than later to reduce their taxable estate.’
1. Know the rules
You need to be worth £325,000 if you are single, or £650,000 jointly if you are married or in a civil partnership, for your loved ones to have to pay IHT.
This basic threshold is called the ‘nil rate band’. But there is a further allowance of £175,000 per person, known as the ‘residence nil rate band’, which increases the threshold to a joint £1 million if you have a partner, own a property and, crucially, leave money to children or grandchildren.
2. Crunch your sums
Work out how close you will be to having a taxable estate with pensions included and what that means for future IHT liabilities – it might make you realise you’re worrying for no reason. Don’t forget you could spend down your pension significantly in retirement.
3. See a financial adviser
If it is a more complex scenario, for example you are a couple aged over 75 and your beneficiaries would have to pay income tax on an inherited pension, one-off financial advice could help navigate the IHT minefield.
4. Devise a sensible plan
Don’t shy away from talking over IHT plans with the family.
- Are you worried about pensions and IHT? Get in touch: [email protected]
Currently, their total taxable estate minus their £900,000 pension and tax-free allowances, is £370,000 with an IHT bill of £148,000 – this includes a savings pot of £40,000 and Isa of £80,000.
By 2030, their pension pots will fall in value as they withdraw their cash, but the value of their estate will still increase to £2,311,619 as pensions are included. It means that the total taxable estate increases to £1,467,429, as taper relief reduces the residence nil rate band, with a painful IHT bill of £586,972.
Unlike our previous families, there is a much lower IHT threshold for a single divorced woman in her mid-40s because she cannot combine her allowances with those of her husband to create a £1million tax-free estate.
Her child will only be entitled to use her nil rate band of £325,000 and the residence nil rate band of £175,000. It means her £450,000 mortgage-free home can be passed on with no IHT if she were to die today.
Her £40,000 saved across cash and Isas, plus £30,000 in a pension pot (which currently isn’t included in her estate for IHT), means her child will not incur any tax on the £490,000 estate today.
By 2030, the value of her home will increase to £509,134, while her pension pot would be valued at £38,288, according to Quilter’s analysis. She will also see her Isa and cash savings increase to £25,526 and £22,628, respectively.
Her taxable estate only needs to breach the £500,000 threshold to incur IHT. The inclusion of pensions in her estate means it will be worth £595,576 by 2030, so her child will face a £38,230 tax bill.
Current IHT rules mean a widower in his early 70s will still have access to the £1million tax-free allowance, if their deceased partner has passed on their nil rate band and residence nil rate band. In this scenario, he will not have to worry about IHT on his £750,000 mortgage-free home because it falls within his tax-free allowance.
Similarly, £50,000 in his Isa and £10,000 in cash, plus a £300,000 pension pot, means his total taxable estate is £810,000 and his beneficiaries will currently pay no IHT. By 2030 the value of his home will be nearly £850,000 while his other assets will have appreciated.
This brings his total taxable estate to just over £1.1million, including his pension pot which we presume has fallen to £200,000 as he withdraws cash, either to spend on himself or his family.
It still pushes his estate above the tax-free allowance threshold so his children and grandchildren will have an IHT bill of £49,474.
This İs Money
